Posted by: Nick Leiber on September 3, 2009

The first blog in this series discussed how while some words do have legal weight, agreements should still be written in clear, understandable language in order to do what they’re meant to. The second in the series examined warranties, and the third non-disclosure provisions. This fourth (and for now final) entry will focus on indemnification provisions.

Indemnification is a very straightforward concept: if party A does something that causes losses or damage to party B, A will pay to fix B. Indemnification encourages each party to concentrate on the risks it controls rather than worrying about problems only the other party can avoid. While either could sue the other to force payback in the event of a problem, putting an indemnification provision in the contract minimizes the time, expense and uncertainty of the process by at least hopefully avoiding the need for a lawsuit. The key to these provisions, though, is what is (and isn’t) covered.

Here’s the indemnification provision from the Web development agreement, written from the perspective of the client (which is important to know, as you’ll see):

Developer hereby indemnifies and shall defend and hold harmless Client, its affiliates, and its and their respective officers, directors, employees and agents from and against all liability, damages, loss, cost or expense (including but not limited to reasonable attorneys' fees and expenses) arising out of or in connection with any actual or threatened claim, suit, action or proceeding relating to any breach by Developer of its warranties hereunder. It is understood that this indemnity shall not apply to any claim solely relating to the Client Content.

Client hereby indemnifies and shall defend and hold harmless Developer, its affiliates, clients and their respective officers, directors, employees and agents from and against all liability, damages, loss, cost or expense (including but not limited to reasonable attorneys' fees and expenses) arising out of or in connection with any actual or threatened claim, suit, action or proceeding relating to the ownership in or the use or exploitation of the Client Content by Developer, including, but not limited to, any claim relating to the violation of any third party's trademark, copyright, patent, trade secret or other proprietary or personal rights in connection with the Client Content.

Upon the assertion of any claim or the commencement of any suit or proceeding against an indemnitee by any third party that may give rise to liability of an indemnitor hereunder, the indemnitee shall promptly notify the indemnitor of the existence of such claim (unless failure to give such prompt notice shall not materially prejudice the indemnitor's rights) and shall give the indemnitor reasonable opportunity to defend and/or settle the claim at its own expense and with counsel of its own selection. The indemnitee shall cooperate with the indemnitor, shall at all times have the right fully to participate in such defense at its own expense and shall not be obligated, against its consent, to participate in any settlement which it reasonably believes would have an adverse effect on its business. An indemnitee shall not make any settlement of any claims which might give rise to liability of an indemnitor hereunder without the prior written consent of the indemnitor.

As with the other blogs in this series, taking the provisions one at a time helps to clarify what they do and don't say:

Developer hereby indemnifies and shall defend and hold harmless Client, its affiliates, and its and their respective officers, directors, employees and agents

The developer's obligations extend not only to its client but related companies and their employees and agents. The client's obligations are similar, but also cover the developer's other clients, a broader obligation that the client's lawyer might not wish to volunteer, but which may also not add significant additional exposure to the client.

from and against all liability, damages, loss, cost or expense (including but not limited to reasonable attorneys' fees and expenses) arising out of or in connection with any actual or threatened claim, suit, action or proceeding relating to any breach by Developer of its warranties hereunder. It is understood that this indemnity shall not apply to any claim solely relating to the Client Content.

The indemnification includes a wide variety of the client's potential damages from actual or potential legal action, including paying for attorneys to defend it from any lawsuits that are covered. Note that in this version of the provision, the developer's obligations are limited to breaches of whatever warranties it gave. That means that, in order for the client to know how much protection it has, it must read the warranties very carefully. The provision also excludes any lawsuits the client may face solely because of the material it provided to the developer ("Client Content"), a fair point since the developer is not responsible for the origin or choice of that material.

Because this agreement was written from the client's perspective, the obligations on the client are narrower, protecting the developer only from "any actual or threatened claim, suit, action or proceeding relating to the ownership in or the use or exploitation of the Client Content by Developer, including, but not limited to, any claim relating to the violation of any third party's trademark, copyright, patent, trade secret or other proprietary or personal rights in connection with the Client Content." None of the other warranties or acts by the client is automatically covered by this indemnification, so if the developer did sustain losses because of something else the client did, the developer would have to actually bring a lawsuit against the client to get reimbursed.

Upon the assertion of any claim or the commencement of any suit or proceeding against an indemnitee by any third party that may give rise to liability of an indemnitor hereunder, the indemnitee shall promptly notify the indemnitor of the existence of such claim (unless failure to give such prompt notice shall not materially prejudice the indemnitor's rights) and shall give the indemnitor reasonable opportunity to defend and/or settle the claim at its own expense and with counsel of its own selection.

This is about the process of indemnification, and applies equally to both parties. It ensures that if there is a potential indemnification claim, the party that has to cover the costs is notified quickly if that's necessary in order for it to be able to minimize its exposure. It also says that whichever party has to pay the damages (the "indemnitor") gets to hire a lawyer and fight the claim if it would prefer, instead of simply paying for the lawyer and court costs of the other party (the "indemnitee"). Again, giving the choice to the party that will be stuck with the bill is the fair approach.

The indemnitee shall cooperate with the indemnitor, shall at all times have the right fully to participate in such defense at its own expense and shall not be obligated, against its consent, to participate in any settlement which it reasonably believes would have an adverse effect on its business.

The party whose costs are to be covered must cooperate with the indemnifying party to fight the claim. If the indemnifying party has chosen to take on the case itself, the indemnified party may still hire a lawyer, but it won't get reimbursed for that. Even if the indemnifying party is in control, though, it doesn't have the ability to settle the case in such a way that damages the indemnified party's business.

For example, Web developer Murrayco is sued because of something client Fredco gave it to put into the Web site. Fredco agrees to indemnify and takes control of the lawsuit. If, though, Fredco is offered a settlement which includes both money damages and a promise that Murrayco will never build another Web site, Murrayco does not have to cooperate with that settlement even if Fredco is willing to accept it and cover the financial cost.

An indemnitee shall not make any settlement of any claims which might give rise to liability of an indemnitor hereunder without the prior written consent of the indemnitor.

By the same token, if Murrayco is sued for $10 million because of Fredco's content, Murrayco may not offer to settle the suit immediately for the full amount, counting on Fredco to indemnify it and pay the settlement, without Fredco's agreement. Instead, each party gets the right to block the other from making burdensome decisions about it without its consent.

One final and critical point: indemnification is only as good as the financial strength of the party offering it. If Murrayco is successfully sued for $5 million, it may be entitled to indemnification for the full amount by Fredco, but if Fredco only has $500,000 in assets, Murrayco will be responsible for the remaining $4.5 million without any remedy. To address the risk of parties' obligations outstripping their financial resources, the contract can also require the parties to obtain sufficient insurance to cover the indemnification, with the other party being named as an "additional insured" under the policy. That way, if the indemnifying party is bankrupt and unable to fully pay, the insurance can make up the difference.

Jonathan I. Ezor is the director of the Touro Law Center Institute for Business, Law and Technology, and an assistant professor of law and technology. He also serves as special counsel to The Lustigman Firm, a marketing and advertising law firm based in Manhattan. A technology attorney for more than 15 years, Ezor has represented advertising agencies, software developers, banks, retailers, and Internet service providers, and has been in-house counsel to an online retailer, an Internet-based document printing firm, and a multinational Web and software development company.

Reader Comments

Gary Brown

September 4, 2009 6:07 PM

Thank you for the interesting and well-written indemnity article.

I think it is also important to note the distinction between defense and indemnity, particularly if the indemnity extends beyond the breach of warranty provisions in this agreement.

Liability can arise from many sources, including injuries to third parties caused by the negligence of either indemnitor or indemnitee, or both, or even by parties not related to the agreement.

Situations arise where the indemnitor defends the injury claim, but in the end it is determined that the injury was mainly caused by the indemnitee, or someone outside the indemnification.

It can be very helpful to those drafting or reviewing indemnity provisions to be aware that language can limit or spread the responsibility for paying the liquidated claim or judgment and still retain the power to control the defense of the claim.

Similarly, the indemnity itself can be divided among the parties that cause the loss. In California, the law of negligence divides responsibility with something we call comparative fault. Essentially, that means that each party pays a share of the loss based upon the extent to which that party caused the injury or loss.

Adopting a policy of drafting and accepting indemnification provisions that achieve this balance of responsibility is in my view a fair and reasonable standard and is a very defensible position, especially when negotiating terms with a more powerful indemnitee.

Parties with greater perceived negotiating strength often try to shift as much risk to the "weaker" party by requiring indemnity for more than the indemnitor's comparative responsibility. Often the weaker party turns a blind eye to such provisions to get the deal. But, even one loss can be very onerous.

Ask yourself whether your business should be paying for something that is caused by someone else, even if it's insured. If your don't think you should, negotiate a comparitive fault indemnity. Ask the other party why your company should assume the risk for losses to the extent the loss was caused by the someone else.

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What's it like to run your own company today? Entrepreneurs face multiple hurdles new and old, from raising capital and managing employees to keeping up with technology and competing in a global marketplace. In this blog, the Small Business channel's John Tozzi and Nick Leiber discuss the news, trends, and ideas that matter to small business owners. Follow them on Twitter @newentrepreneur.